SCHF: How International ETFs Might Outperform The U.S. Market

seekingalpha05-22

Schwab International Equity ETF is a buy due to its attractive valuation and potential for strong returns in international equities.SCHF offers broad diversification at a low cost and has a dividend ...

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Nikada Investment Thesis Schwab International Equity ETF (NYSEARCA:SCHF) is a buy due to multiple macro-level factors impacting international equities. Despite lagging U.S. total market and S&P 500 funds over the past decade, international funds have strong potential looking forward due to their attractive valuations. SCHF also offers broad diversification at a low cost and a dividend yield that surpasses U.S. S&P 500 and total market funds. Fund Overview and Compared ETFs SCHF is an ETF that seeks to track returns of the FTSE Developed ex US Index. Therefore, the fund predominantly captures companies in nations considered developed (versus emerging markets) and excludes U.S. holdings. The fund was created in 2009 and has 1,525 holdings with $38.2B in assets under management. SCHF is heaviest by sector in financials (20.47%), followed by industrials (16.89%) and consumer discretionary (11.59%). By nation, SCHF holds 22.36% weight in Japan, 12.30% in the United Kingdom, and 9.66% weight in France. The fund is mostly large cap, but has 17.82% weight in holdings with less than $15B in market capitalization. For comparison purposes, other funds examined are the Vanguard FTSE All-World ex-US ETF (VEU), iShares MSCI ACWI ex U.S. ETF (ACWX), and iShares Core MSCI Total International Stock ETF (IXUS). VEU is more diversified than SCHF and includes 25.7% weight on emerging markets. ACWX is similar to VEU with some deviations such as greater weight on Chinese holdings and less weight on Japanese companies. IXUS is another iShares fund like ACWX but is more broadly diversified with over 4,000 holdings and includes more small-cap holdings than ACWX. Performance, Expense Ratio, and Dividend Yield SCHF’s 10-year average annual performance has been 4.56% and its total price return over the past decade is 22.3%. By comparison, SCHF has outperformed peer VEU with a 10-year average annual return of 4.21%, while ACWX saw a 4.13% 10-year average return, and IXUS saw a 4.44% 10-year average return. Despite this outperformance among international funds, SCHF has significantly lagged U.S. total market and S&P 500 Index funds. Therefore, one might wonder why we should invest in international at all, given the significant underperformance. I will cover a few reasons why this 10-year trend is due for a potential reversal later. 10-Year Total Price Return: SCHF and Compared International Equity ETFs (Seeking Alpha) A key advantage for SCHF is its low expense ratio. At 0.06%, SCHF has the lowest fees of compared funds and well below the average for all ETFs. However, SCHF’s dividend yield is a bit lower than peer funds, particularly VEU. All international funds have had growing dividend yields with a 5-year CAGR of at least 4%. Expense Ratio, AUM, and Dividend Yield Comparison     SCHF VEU ACWX IXUS   Expense Ratio 0.06% 0.07% 0.34% 0.07%   AUM $38.19B $54.27B $4.79B $37.57B   Dividend Yield TTM 2.76% 3.25% 2.74% 2.90%   Dividend Growth 5 YR CAGR 4.79% 5.37% 6.75% 5.18%   Click to enlarge Source: Seeking Alpha, 21 May 24 SCHF Holdings and International Investment Outlook Despite the massive diversification for each fund, their top holdings look relatively similar. However, SCHF lacks Taiwan Semiconductor Manufacturing (XTAI:2330) from its top holdings. Instead, Novo Nordisk Class B (NOVO B) shares are the heaviest weight for SCHF. With over 1,000 holdings, SCHF has only 12.73% weight on its top 10 holdings. Top 10 Holdings for SCHF and Peer International ETFs   SCHF – 1,525 holdings VEU – 3,848 holdings ACWX – 1,857 holdings IXUS – 4,362 holdings   NOVO B – 1.93% 2330 – 1.84% 2330 – 2.37% 2330 – 2.04%   ASML – 1.73% NOVO B – 1.43% NOVO B – 1.59% NOVO B – 1.37%   NESN – 1.35% ASML – 1.24% ASML – 1.39% ASML – 1.20%   005930 – 1.29% 7203 – 0.98% 700 – 1.25% 700 – 1.07%   7203 – 1.25% 700 – 0.98% NESN – 1.05% NESN – 0.91%   SHEL – 1.10% NESN – 0.97% 005930 – 1.01% 005930 – 0.87%   AZN – 1.07% 005930 – 0.96% AZN – 0.88% AZN – 0.76%   NOVN – 1.01% SHEL – 0.83% MC – 0.87% MC – 0.75%   MC – 1.00% AZN – 0.81% 7203 – 0.87% 7203 – 0.75%   SAP – 1.00% MC – 0.73% SHEL – 0.86% SHEL – 0.74%   Click to enlarge Source: Multiple, compiled by author on 21 May 24 Because of the many similarities between compared international funds, all are likely to trend in the same direction in performance. Looking forward, I believe there are three main factors that prime each fund, including SCHF, for strong returns, potentially even outpacing U.S. funds. These include the current high valuation for U.S. equities, comparative GDP growth, and an improvement in the Japanese economy, which makes up SCHF’s largest weight by nation. Current U.S. Market Valuation Levels I wrote previously on how I believed the U.S. market is overvalued in my coverage of Vanguard’s Consumer Staples ETF (VDC). Indicators flashing high valuation for U.S. equities include the Buffett Indicator, which measures the total U.S. stock market value dividend by U.S. GDP, and the S&P 500’s current price-to-earnings ratio. Both indicators are well above their historic averages. Additionally, the CAPE, or cyclically adjusted price-to-earnings, ratio is also showing warning signs. At 33.98, the CAPE ratio was only this high at two previous peaks, both just prior to major declines.   Cyclically Adjusted Price-to-Earnings Ratio, 1900-2024 (Robert Shiller Data, cfainstitute.org, 20 May 24) While I previously covered that Warren Buffett has been selling and adding to his cash pile, there are other billionaire investors that are doing the same. Bill Gates sold about 3% of his stake in Microsoft, about $14B, in Q4 ’23. Additionally, Jeff Bezos sold $6 billion in Amazon shares this past February. In contrast to the high U.S. market valuation, international equities are comparatively much more attractive. Expected International Performance As a result of the disparity in valuations and other factors, international stocks may see better performance. Schwab’s own forecast predicts that U.S. large-cap stocks will underperform their historic average, with a 6.2% average return through 2033. In contrast, the forecast for international large cap stocks is brighter, with a 7.6% average annual return forecast over the next decade. The rationale for this difference can be derived from multiple reasons including the current high valuation of U.S. equities, inflation, geopolitics, and interest rates. Forecast Comparative Returns through 2033 (Schwab Investment Advisory, Inc. and Schwab Asset Management) Another key factor is GDP growth. Schwab predicts real GDP growth for the U.S. at just 1.7% through 2033, notably lower than the 2.7% average seen between 1970 and 2023. This is not to say that asset management companies are recommending 100% allocation in international equities, however. Vanguard’s guidance is that investors should allocate at least 20%, but ideally 40%, of a portfolio in international holdings. Personally, I have approximately 22% percent in broad-based international funds but I am looking to target 25%. Japan’s Economic Growth Of course, the performance of international funds is based on the expected returns of many individual companies and countries that it contains. One very promising nation that has high weight in all examined international funds is Japan. Unfortunately, the nation has seen a history of economic difficulties including an aging population, deflation, and GDP growth. The Nikkei 225, the Tokyo Stock Exchange’s stock market index that includes its top 225 blue-chip companies, saw a peak in the early 1990s, then proceeded to see an 80% decline. However, the nation is seeing a rebound. Nikkei 225 Index 1980-Present (Nikkei Industry Research Institute, FRED, 20 May 24) Since the start of 2023, the Nikkei 225 has seen returns akin to the S&P 500 Index. Corporate profits have been strong, and the relative valuation compared to U.S. companies is also attractive. One example is Toyota Motor Corporation (TYO:7203). The Japanese car company has seen strong fundamentals, including a 21.4% YoY revenue growth with $27B cash from operations over this past year. Interestingly, Warren Buffett's stake in Japanese holdings has increased from 5% in 2020 to 7.4% today. Current Valuation Because of the similarities in funds, SCHF and peer competitors have performed on par with each other this past year, with SCHF seeing a slight outperformance. As seen in the 10-year look back, all funds underperformed the U.S. market, with the S&P 500’s one-year return over 26%. One Year Performance: SCHF and Peer International Funds (Seeking Alpha) This difference between U.S. and international funds has also resulted in very different valuations. While the S&P 500 Index’s P/E ratio stands at a high 27.58, SCHF and peer funds are much more attractive. With a P/E of 15.31 and P/B of 1.76, SCHF is comparable to the other examined international funds but significantly more favorable than broad-based U.S. funds. Valuation Metrics for SCHF and Peer Competitors     SCHF VEU ACWX IXUS   P/E ratio 15.31 14.90 15.93 15.75   P/B ratio 1.76 1.80 1.91 1.82   Click to enlarge Source: Compiled by Author from Multiple Sources, 21 May 24 Risks to Investors International ETFs, in particular those heavy on developed markets such as SCHF, have a high degree of correlation with the U.S. market. Therefore, investors should not consider SCHF an uncorrelated asset. Additionally, with a 3-year standard deviation of 17.1%, Schwab’s international fund is roughly as volatile as U.S. funds, as measured by the S&P 500 with a 3-year standard deviation of roughly 18. While foreign holdings present a certain level of geopolitical risk, the broad diversification with 1,525 holdings mitigates this risk. All above factors aside, I believe the greatest risk to investors in SCHF is the risk of opportunity cost. Despite more attractive valuations for international holdings, there are many reasons to remain optimistic about the outlook for U.S. domestic equities. These include the prospects of reduced interest rates, the avoidance of a recession, and the taming of inflation. Therefore, perhaps the greatest risk to investors is the potential for continued international underperformance. As my favorite investor said in an annual shareholder letter, “Never bet against America.” Concluding Summary  Despite the clear underperformance for international stocks over the past decade, there have been historic cycles of outperformance. Given the strong returns for the U.S. market, valuations as measured by CAPE and P/E ratios are concerning. Therefore, while international funds have a high correlation to U.S. funds, there are more attractively valued. This difference in valuation drives me to consider SCHF as a buy looking forward. While geopolitical risk exists with international holdings, SCHF is highly diversified to mitigate this risk. SCHF has numerous similarities with peer funds, but has a very competitive expense ratio and noteworthy dividend yield.","kind":"highlight","is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.29.3","shortVersion":"4.29.3","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2437815239"}